City of Farrell v. Sharon Steel Corp.

Citations: 41 F.3d 92; 1994 WL 636479Docket: No. 94-3130

Court: Court of Appeals for the Third Circuit; November 14, 1994; Federal Appellate Court

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The appeal concerns municipal income taxes withheld by Sharon Steel Corporation from its employees' wages for the City of Farrell. After withholding $56,831.99 for the fourth quarter of 1992 and subsequently filing for Chapter 11 bankruptcy, Sharon Steel remitted only a portion of the withheld taxes ($7,944.97) to the city, retaining the remainder. The City of Farrell sought to compel the turnover of these funds in bankruptcy court, arguing that withholding creates a trust for the taxing authority, referencing the Supreme Court case Begier v. IRS.

However, the bankruptcy court denied the city's motion, determining that the city could not establish the necessary connection between the withheld taxes and the commingled funds in Sharon Steel’s possession. The court noted that, unlike in Begier, where the debtor had created a segregated trust fund by paying taxes prior to filing for bankruptcy, Sharon Steel had not segregated the funds, and therefore, they remained part of the debtor’s estate. The district court affirmed this ruling, agreeing that the facts were distinguishable from Begier and highlighting the absence of statutory language establishing a trust fund in the relevant local tax laws. The appellate court has decided to reverse the district court’s order and remand the case for further proceedings.

On February 14, 1994, the district court affirmed the bankruptcy court's order regarding the City of Farrell's motion to lift the automatic stay and compel turnover of trust fund taxes. The City appealed, asserting that the funds withheld by Sharon Steel from employee wages for the fourth quarter of 1992 are not part of the bankruptcy estate under 11 U.S.C. 541(d), which excludes equitable interests of third parties. The courts below ruled that if the funds are property of the estate, the city's claim is invalid, but if they are not, the city should receive the funds unless the pre-petition lenders of Sharon Steel have a claim.

The City argues that the withheld funds were retained in trust for it, thus exempting them from the estate. The review of this appeal is plenary, as the case was decided on undisputed facts. The established principle is that debtors do not hold an equitable interest in property they hold in trust for others, making trust-held funds not part of the bankruptcy estate. Claimants must establish the trust relationship and trace the trust funds if commingled, with state law determining the trust relationship and federal law governing the tracing of funds. 

The case references Begier, where the Supreme Court determined that withheld taxes paid to the IRS were not considered the debtor's property but were held in trust for the government, thereby supporting the City's position that similar circumstances apply to the withheld wages in question.

The Court determined that the debtor's pre-petition payments to the IRS established a sufficient connection to remove those funds from the bankruptcy estate. The city argued that the precedent set in Begier necessitated reversing the lower courts' decisions that denied its motion to lift the automatic stay and compel turnover of withheld funds. The district court cited two main reasons for its denial: (1) the city did not demonstrate that a statutory trust existed, and (2) it failed to establish a clear nexus between the debtor's assets and the withheld funds. 

Sharon Steel and Citibank contended that the district court's ruling was correct and that Begier was not applicable, warranting affirmation of the bankruptcy court's order. The district court examined whether a trust was created for the withheld taxes, concluding that there was no statutory basis for the city's claim. However, it acknowledged that the statute referenced in Begier, 26 U.S.C. 7501, indicates that employer-withheld taxes are held in trust for the United States.

The city argued Pennsylvania law supports the notion that Sharon Steel established a trust for the city. The court agreed that the determination of trust creation should consider the entire relevant state law and case law, not just the statutory authority. Referencing Pennsylvania case law, particularly Penn Plastering, the court found that when Sharon Steel withheld city income taxes, a trust was indeed created. The precedent established that an entity collecting taxes as an agent for a city becomes a trustee for those funds and is obligated to remit them to the city, supporting the conclusion that a trust existed for the withheld taxes.

Corporations act through individuals, and when those individuals, as controlling officers, neglect their trust responsibilities, they become personally accountable for those obligations. Under Pennsylvania law, if a corporation withholds municipal income taxes, it assumes a 'trust responsibility,' treating the withheld funds as a trust for the municipality. This principle is supported by the Heinel Motors case, which established that when a vendor collects sales tax, they hold those funds in constructive trust for the state, as the tax is levied on the purchaser. The court emphasized that anyone receiving funds meant for another is considered a trustee. The distinction between how sales and income taxes are collected does not alter the conclusion that employers are merely conduits for the taxes owed by employees. Consequently, under Pennsylvania law, withholding taxes are held in trust for the municipality. Furthermore, the trust created under Pennsylvania law is comparable to the trust established under federal law in Begier, which mandates that withheld taxes are held in trust for the government, effective at the moment wages are paid, and does not require segregation of funds. Both frameworks necessitate that employers withhold taxes when paying wages to employees.

Pennsylvania case law establishes that a trust is created when an employer withholds taxes, and Section 7501 of the Internal Revenue Code specifically creates an express trust in those withheld funds upon the payment of wages. The Begier Court's reasoning against requiring segregation of withheld funds as a condition for trust creation is applicable here; if segregation were necessary, employers could evade trust creation by commingling withheld funds with other assets. Acknowledging the city’s equitable interest in the withheld funds is crucial, despite the absence of an express trust under Pennsylvania law. The distinction between explicit and constructive trusts does not impact this case, as Congress intended Section 541(d) to exclude both types of trusts from a debtor’s estate. The Ninth Circuit has suggested that the same rule applies to constructive trusts. The core issue is whether the withholding funds qualify under Section 541(d) as non-property of the estate, and the nature of the trust—whether constructive or express—does not affect this determination. Consequently, since a trust was created under Pennsylvania law when Sharon Steel withheld the income tax, the district court erred in its finding that the City of Farrell failed to demonstrate a trust relationship. Additionally, the Begier decision analyzed whether specific funds paid to the IRS were considered trust property, paralleling the requirement for claimants to identify and trace trust funds, a principle that is relevant to the present case.

The Court determined that common-law tracing rules are not applicable in this context, as a section 7501 trust is defined by an abstract monetary amount rather than specific assets. Consequently, the Court decided to analyze the trust in a manner consistent with the Begier decision rather than relying on common-law tracing to assess whether the city met Begier’s nexus requirement. The reference to United States v. Randall highlighted a similar situation where the IRS attempted to claim a debtor’s pre-petition tax obligation from post-petition assets without a segregated fund. The Randall Court ruled against this, prioritizing administrative costs over tax claims. However, Begier established that the strict rule from Randall was overridden by the new Bankruptcy Code section 541, which clarified that trust-fund taxes do not constitute property of the estate. The Begier Court noted the legislative history, indicating that the Senate bill directly countered Randall by asserting that withheld trust-fund taxes were excluded from the estate, while the House bill implied similar principles. The final compromise in section 541 acknowledged that while the legal title of trust property enters the estate, the beneficial interest does not. Begier also considered congressional floor statements as persuasive evidence of intent, reinforcing that withheld trust-fund taxes should not be included in the bankruptcy estate.

Begier emphasized the significance of Representative Edwards' discussion regarding the relationship between the House language and the rule established by Randall. The Court determined that Congress intended for the IRS to demonstrate a connection between the section 7501 trust and the assets sought for trust-fund tax obligations, specifically at the time of the bankruptcy petition filing. The Court found that a pre-petition payment to the IRS fulfilled the nexus requirement in Begier. However, in the current case, the absence of a pre-petition payment prevents a conclusion regarding the City of Farrell's compliance with the nexus requirement. 

Sharon Steel contends that the nexus cannot be established since the taxes were not segregated or paid prior to the petition. This argument misinterprets Begier, which suggests that the nexus requirement could be met through alternative means, not solely through segregation or pre-petition transfers. Representative Edwards indicated that if the IRS cannot prove the withheld taxes were in the debtor's possession at the time of the case's commencement, those taxes are generally considered property of the estate. 

A challenge arises when trust fund taxes are mingled with the debtor's other assets, complicating the determination of their status. Courts should allow reasonable assumptions for the IRS to demonstrate that withheld taxes remain with the debtor. For instance, if withheld taxes are commingled in a general account, it could be reasonable to assume that any remaining balance constitutes withheld taxes. However, the lack of factual findings from the bankruptcy and district courts prevents a definitive assessment of whether the City of Farrell has met the nexus requirement. The courts believed that the City could not satisfy this requirement due to the commingling of funds and the failure to pay taxes before filing for bankruptcy, though Representative Edwards' example remains relevant in evaluating potential assumptions in this context.

Sharon Steel acknowledges that prior to its bankruptcy filing, Citibank managed its funds through a lock box account, authorizing disbursements to Sharon Steel's operating accounts. This arrangement implies that the funds withheld might be considered held in trust for the City of Farrell. Upon filing for Chapter 11, the lock box account may have contained funds exceeding those withheld. This scenario aligns with the situation Representative Edwards described, involving commingled trust-fund taxes in a debtor's general account. Due to insufficient facts to assess whether the City of Farrell meets the nexus requirement, the case is remanded to the district court, which will further remand it to the bankruptcy court for fact-finding. The courts are instructed to consider the 'lowest intermediate balance test' (LIBT), which aids beneficiaries in tracing commingled trust funds by allowing them to assume withdrawals occur last from such accounts. While the applicability of the LIBT has not been definitively decided, it may assist the IRS and other taxing authorities in proving the retention of withheld taxes by the debtor at the case's commencement. Sharon Steel argues that the city waived its right to discovery, relying solely on the Begier case; however, the city contends that procedural barriers prevented discovery in the bankruptcy court. The argument is moot as the bankruptcy court found no segregated trust fund existed, and thus, discovery would not have been relevant to the key legal issues. Given that the bankruptcy court misapplied the law, remanding for fact development is warranted to meet the nexus requirement properly, countering Sharon Steel's position against further findings.

Citibank, acting as an agent for certain lenders, claims that the Cash Collateral Account is the sole source for paying taxes owed by Sharon Steel, which is tied to a prepetition credit agreement securing the lenders' prior lien. Citibank argues that without the lenders' consent, the taxes cannot be paid, and since the lenders do not consent, payment is impossible. This argument was not addressed by either the district or bankruptcy courts, nor was it sufficiently briefed in the appeal, although Citibank referenced it briefly.

The determination of how Sharon Steel's funds were handled remains unclear. Consequently, the court refrains from evaluating Citibank's argument at this time but allows for its potential advancement upon remand. The court reverses the district court's February 14, 1994 order and remands the case for further proceedings. It instructs the bankruptcy court to investigate Sharon Steel's wage payments and tax withholdings, including the accounts involved, their deposit and withdrawal histories, and remaining balances at the bankruptcy filing.

Additionally, Citibank may argue that the lenders it represents have a lien on the funds sought by the city. Under 11 U.S.C. § 541(a)(1), property of the estate includes all legal or equitable interests of the debtor at the case's commencement, but § 541(d) states that property held by the debtor with only legal title, not equitable interest, becomes estate property only to the extent of that legal title. The court notes that trust beneficiaries hold equitable interests while legal title rests with the trustee. Determinations of property rights in bankruptcy are generally based on state law, even as federal law may clarify trust relationships and tracing of trust funds. The case In re Markos Gurnee is cited to illustrate the distinction between trust-fund taxes and other tax obligations, emphasizing that not all tax statutes create a trust in favor of a state.

The Markets Gurnee court clarified the distinction between trust fund taxes, such as income tax withholding, and other taxes by stating that trust fund taxes are imposed on one party but collected by another. However, it found this principle inapplicable to the occupation tax, which is directly imposed on hotel operators rather than their customers. Regarding the use tax, the court noted that the statute creates a creditor-debtor relationship between the state and the party responsible for remitting the tax. 

In contrast, the City of Farrell’s income tax is levied on employees, not the employer, Sharon Steel. The court acknowledged that an employer might lack the funds to cover gross wages, potentially challenging the notion of a trust for withheld taxes, although it did not address this argument since neither Sharon Steel nor Citibank raised it. 

The court referenced the City of Farrell's ordinance requiring employers to deduct income tax at the time of wage payment. It cited the Begier case, which clarified that payments of withholding taxes are treated as trust payments under the Internal Revenue Code and are not considered preferences in bankruptcy if properly held for payment. 

Finally, the court pointed out that Begier involved pre-petition payments to the taxing authority, while the current case involves the authority's attempt to collect taxes from the debtor's post-petition assets, indicating that the nexus requirement may still be satisfied through other means despite the specific circumstances in Begier.

The bankruptcy court referred to two cases, In re Kulzer Roofing, Inc. and In re Russman's, Inc., to evaluate the City of Farrell's claim regarding commingled funds held by Sharon Steel. The court determined that the City of Farrell failed to establish the necessary nexus for its claim, noting that Kulzer did not involve a taxing authority and that the claimants had not proven the existence of an express or constructive trust over the commingled assets. Although Kulzer is distinguishable, the court found Russman relevant as it addressed trust-fund issues related to sales taxes. Russman confirmed that a state taxing authority could demonstrate a nexus with segregated funds but not with commingled funds, a conclusion the court found unpersuasive due to a lack of analysis.

The court emphasized that the determination of whether a trust exists differs from whether the trust funds are traceable, highlighting that the inquiry into state law does not always overlap with the traceability of funds. It noted that equitable considerations should inform the nexus inquiry, supporting the argument that a party should not be able to render a trust unenforceable by commingling assets. The court rejected the notion that the City of Farrell should not benefit from Representative Edwards’ remarks simply because it is not the IRS, asserting that the principles discussed apply broadly to other taxing authorities as well.